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Caterpillar, IRS And The US Tax Conundrum

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The construction-equipment company could potentially have to pay billions in tax fines to the IRS. Other US-based companies with global operations too will have to take a hard look at how they pay their taxes.

A symbol of American manufacturing, Caterpillar finds itself at the center of a tax controversy involving the Internal Revenue Service (IRS). At stake is a potential $2 billion tax bill for the company and a restructuring of how US-based companies with global operations may pay their taxes in future.

Caterpillar has long used Caterpillar SARL, its subsidiary in Switzerland, to process sales and profits for international orders. According to a 2014 US Senate Committee report, the company pays an effective corporate tax rate of just 4% to 6% on this revenue. This is also much less than the 21% corporate tax rate passed by President Trump's administration in December 2017.

The IRS claims that between 2007 and 2012, Caterpillar processed international sales illegally to reduce its effective tax rate. Caterpillar, on its part, claims that its practice is legal and common among US companies operating globally.

According to media reports, the IRS could not find the proper documentation supporting the exports of replacement parts to the company’s global customers. Caterpillar is accused of improperly attributing these sales to its lower-tax subsidiary, instead of the higher-tax jurisdictions that generated the sales.

Agents from the Commerce Department, the IRS and the Federal Deposit Insurance Corporation raided Caterpillar’s offices and warehouse in Illinois in March last year.

Transfer Pricing Conundrum

At the heart of the IRS-Caterpillar tussle are the long-standing transfer pricing practices used by US multinationals to reduce and structure tax payments by processing sales in lower-tax jurisdictions.

These may now be impacted by some of the new provisions in the newly approved US tax law, most notably, the lower corporate tax rate of 21% and the one-time reduced tax on repatriated profits from foreign subsidiaries—15.5% on cash and equivalents and 8% on real estate and other illiquid assets.

While the new tax law could see some restructuring by global companies to update some of the questionable transfer pricing strategies, firms would still need to account for significant legal, accounting and other compliance costs as part of their total calculation.

Geography Matters

US companies could react differently to the tax reforms depending on the unique global markets they operate in. For instance, many US technology companies, such as Apple, have established significant technology research-and-development centers in Israel, a vibrant global tech hub. Tech firms may also use the country as a base for their global supply chains, as is the case with chip manufacturer Intel.

US tax reform has triggered a conversation about the possibility that US tech companies will pull out of Israel and what Israel needs to do to maintain its economic competitiveness. Israel’s finance minister has announced potential corporate tax cuts in order to keep US operations in Israel.

As for the transfer of funds between corporate entities and transfer pricing, Moshe Asher, the head of the Israel Tax Authority, referred to the significantly new lower US corporate and repatriation tax rates and noted, “All the funds will fly from outside the US to inside the US. You’ll have no reason to leave it outside the US.”

Challenges For The IRS

The IRS faces a dramatically changing regulatory environment, even as it continues to oversee investigations such as the Caterpillar case.

The tax authority has been facing budget and personnel cuts in recent years, and Trump had threatened to continue that trend during his presidential campaign.

IRS commissioner John Koskinen, whose term ended just a few weeks ago, warned at the National Press Club, “The biggest challenge facing the IRS today [is] the substantial decline in our funding, which puts significant strain on our ability to provide adequate service to taxpayers and to maintain strong service and enforcement levels to ensure the integrity of our voluntary compliance system.” More funding cuts may affect the tax authority’s ability to pursue such cases and investigations in the future.

For now, American companies are watching the IRS-Caterpillar case closely. US federal law states that a company cannot enter tax shelters simply to avoid taxation; it must have a legitimate business reason for doing so. So far, Caterpillar has maintained that its Swiss subsidiary is perfectly legal. A ruling by the IRS will set the precedent for how US companies structure their tax strategies globally in the new era of the US tax reform.